Tuesday, February 3, 2009

Questions on US Economy

Do you think if the US chooses to print the money it will turn into hyper inflation?

It is complicated because at moment, the velocity of circulation (number of transactions) is falling meaning that increasing money base is not causing inflation. But, they need to be careful, if monetary base keeps rising and then velocity of circulation recovers, the US could see a sharp rise in inflation. (Money Supply and inflation in US)

Or will it cause countries around the world to dump dollars leaving the US with worthless money?

If US experiences inflation, then the dollar will depreciate depending on the extent of the inflation. Markets may start to take fright at US policies of quantitative easing, but, at the moment, US is still seen as a relatively safe haven compared to the financial turmoil in the rest of the world. Whether markets will regret seeing the US as a relative 'safe haven' we shall find out in the future.

Or will printing the money actually stop deflation?

Yes, deflation is the primary concern at the moment. The Fed are quite worried about deflation. If deflation sets in the recession will worsen and it makes normal monetary policy ineffective. Deflation makes it very difficult to recover from recession. Therefore, although there are concerns with quantitative easing, the biggest immediate threat is deflation (e.g. Japan in 1990s and 2000s). The last time US had deflation was in the Great Depression. Deflation can be a harbinger of depression. (see: costs of deflation)

Instead of printing the money, if US chooses to issue more debt, who will buy it and what would it mean if foreign countries buy it up?

Upto now, foreign countries such as Japan, China and UK have been buying US debt e.g. US treasury bills and gilts. It is seen as a relatively safe investment (safer than say private sector savings). It means that approximately 25% of US government debt is held externally by countries like China and Japan. These capital flows helped to finance the US current account deficit. If foreign countries stopped buying US debt then:

Interest rates on US debt would rise.

US dollar would depreciate.

There is even risk of partial debt default or inflation

And if US falls what does that mean to the rest of the world?

The US is the largest importer of manufactured goods. If the US went into a prolonged recession, it would definitely worsen the global recession. Countries like Japan and China would be hard hit, because to some extent they rely on exports to the US. There would also be a negative effect on global confidence. For all its faults the US dollar is still seen as the world's reserve currency. If the dollar collapsed where would people put their money? In gold?